Update: McKenna at the University of Chicago’s Stigler Center

I returned to Washington D.C. and my job as a journalist at MarketWatch in late June, after almost three months as a Journalist in Residence at the Stigler Center at the University of Chicago Booth School of Business. The Center for the Study of the Economy and the State, as I mentioned in an earlier post, was founded by Nobel laureate George J. Stigler at the University of Chicago in 1977 and is now led by the economist Luigi Zingales. It is “dedicated to understanding the interaction between politics and the economy. It is an intellectual destination for research on regulatory capture, crony capitalism, and the various forms of subversion of competition by special interest groups.”

My fellowship deliverable, in exchange for the opportunity to study with the researchers, was three posts for the Center’s Pro-Market blog on the state of the audit industry.

I was fortunate to have the news of the firms align with some of the major themes the Center focuses on: regulatory capture and subversion of competition by special interests.

A look at the Big Four’s congressional lobbying activity during the first quarter of 2017 shows the auditors and the AICPA, their trade association, taking advantage of the “Trump” window to roll back Sarbanes-Oxley reforms. The industry is targeting the strict SOX auditor independence rules and the authority of the Public Company Accounting Oversight Board, the industry regulator established after Enron and its auditor, Arthur Andersen, collapsed.

It seems I was on to something. Back at MarketWatch this past week I covered back to back events–a speech by SEC Commissioner Mike Piwowar at the Heritage Foundation and a hearing in the House Financial Services Committee on the cost of IPOS–that were both highly focused on criticizing even more elements of the Sarbanes-Oxley Act. With one bill passed in the House that aims to repeal major components of the Dodd-Frank Reform Act of 2001–The Financial CHOICE Act–and one being considered in the Senate, “reformers” are now reaching back to 2002 to find another culprit for what is perceived to be a lack of opportunity for retail investors to “build wealth” by supporting “capital formation” by start-up companies who aren’t going public as fast or as frequently.

Congressional Republicans believe the cost of going public, and being a public company, is too darn high. That means retail investors are missing out on huge gains, since private company “unicorns” are avoiding public markets and the “unnecessary regulatory burdens” imposed by the 2002 Sarbanes-Oxley Act.

In a hearing on Tuesday of the House Financial Services subcommittee on capital markets, Rep. Warren Davidson, a Republican from Ohio, compared the stock market to buying a ticket to the lottery. “We don’t stop people from spending money on lottery tickets and clearly the risk of losing your capital in the lottery is much greater.”

Rep. Bill Huizenga of Michigan, the subcommittee chairman led the full court press on his fellow lawmakers, and regulators like the Securities and Exchange Commission and the Public Company Accounting Oversight Board—created by Sarbanes-Oxley—to expand investing options for mom and pop investors and remove more obstacles to more capital formation.

Michael Piwowar, a Republican appointee at the Securities and Exchange Commission, agrees with Huizenga and Davidson. At an event at the Heritage Foundation on Monday, Piwowar told the audience he’s questioned the premise of having accredited versus nonaccredited investor categories.

German magazine Der Spiegel has reported that less than six months after PricewaterhouseCoopers’ Switzerland firm took over as auditor of the bribery and corruption-plagued Fédération Internationale de Football Association (FIFA), PwC allegedly covered up a misappropriation of funds by its new secretary general, Fatma Samoura.

I’ve written often about how the audit firms are seamless global organizations in name only, using their branding and marketing to tie the firms together in name only and denying any organizational or legal authority over each other when trouble starts.

Pretty interesting stuff in this European Parliament group study on the “opacity” of the organizational structure of the Big Four accounting firms. According to the study, nobody knows how many offices the Big Four have, exactly where they’re located, how many people work for them, or how their ownership is structured. Why so secretive? The study says that the Big Four have their reasons:

We suggest that the structure adopted by the Big Four firms of accountants, which at one level suggests the existence of a globally integrated firm and at another suggests that they are actually made up of numerous separate legal entities that are not under common ownership but which are only bound by contractual arrangements to operate common standards under a common name, has been adopted because it:

– Reduces their regulatory cost and risk;
– Ring-fences their legal risk;
– Protects their clients from regulatory enquiries;
– Delivers opacity on the actual scale of their operations and the rewards flowing from them.

The study was released by a left-leaning group of members who serve on the European Parliament’s Panama Papers inquiry committee. Anyway, who knew that your mild-mannered independent registered public accounting firm was playing such an integral role in bringing about the “New World Order”?

That’s quite consistent with my writing.

In the FIFA impact post I had a chance to revisit what happened when Big 4 member firms got in trouble with the law outside of the United States and compare those responses to what happened when the troubles, and eventual dissolution, of the U.S. Arthur Andersen firm wreaked havoc on its global network.

Critics might now ask, “Should PwC’s international firm take action against its Swiss member for the alleged cover-up?”

It won’t be easy.

The audit industry’s “global network” model is the legal vehicle used to drive liability around, in a Big Four version of Catch Me If You Can. The firms are members and partners only until trouble hits. When an audit firm anywhere in the world, but especially one that serves multinationals in conjunction with the U.S. firm, faces legal liabilities, lawyers typically deny the “global firm” structure that is otherwise so carefully cultivated in marketing and other public relations materials. But that contradicts actual practice required to preserve the global network of firms needed to service multinationals.

PwC has opted for this tactic before, when problems popped up in their Japanese, Russian, and Indian firms.

Arthur Andersen’s global network collapsed after the firm was indicted by the Department of Justice because its foreign member firms ran to join other networks out of fear of the financial and reputational fallout of their U.S. firm’s involvement with Enron. However, current industry fears center on the impact of shenanigans committed by foreign member firms on American member firms.

On July 24, the National Bank of Ukraine, the country’s central bank, revoked the license of PwC to audit local banks, saying that it had verified “misrepresented financial information in the financial statements” of PrivatBank. PrivatBank was nationalized in December 2016 after the central bank identified a $5.4bn capital shortfall . PwC audited PrivatBank from 2007 until 2015.

A Reuters report said that PwC’s can apply “for the right to once again formally audit banks after a period of three years, a spokeswoman for the central bank said. In the meantime, the subsidiary can perform auditing services but lenders can only submit financial reports that have been audited by firms on the central bank’s register, she said. The central bank estimated that 97 percent of PrivatBank’s corporate loans had gone to companies linked to its shareholders, who include the tycoon Ihor Kolomoisky, Ukraine’s second-richest man.”

There was no going concern-type warning issued before the central bank had to step in and take over PrivatBank.

PwC in the middle of failure due to a capital shortfall of another European bank recently, Banco Popular in Spain. Banco Popular was put into resolution, according to a Financial Times story, “its shareholders wiped out and its junior bonds written down to almost zero, before it was sold to bigger rival Banco Santander for a symbolic €1.”

While a PwC audit forced Popular to restate its 2016 annual accounts in April, it still pegged the bank’s net asset value — the difference between its assets and liabilities — at €10.8bn. The sudden swing into negative equity in the FROB-commissioned reassessment of Popular’s books was largely driven by much higher provisions against its property portfolio — dramatically higher than provisions seen at other Spanish banks, which could have big implications for the Spanish non-performing loan market.

Banco Santander is also audited by PwC. I’ve written at MarketWatch about what some academic researchers says is possible when acquirer and target share an audit firm.

Lone Star has decided to be assisted in the operation by PwC, according to financial sources consulted by Vozpopuli. This firm knows well Popular´s books as it is its auditor, although different teams analyze the accounts and advise the fund.

On 6 June, the European Central Bank (ECB) determined that Banco Popular Español S.A. was failing or likely to fail in accordance with Article 18 (1) of the Single Resolution Mechanism Regulation.

The significant deterioration of the liquidity situation of the bank in recent days led to a determination that the entity would have, in the near future, been unable to pay its debts or other liabilities as they fell due.

Consequently, the ECB determined that the bank was failing or likely to fail and duly informed the Single Resolution Board (SRB), which adopted a resolution scheme entailing the sale of Banco Popular Español S.A. to Banco Santander S.A.

The loss of PwC’s ability to audit banks in the Ukraine for a while, while painful to the pockets of the partners of that franchise, is not a major loss to the PwC global network as a whole. But if PwC were to lose its right to audit in Spain, for example– an important spoke in the hub and spoke service model for multinationals in Europe and that do business in Europe–the global network would potentially be threatened. Fortunately for PwC, no one is blaming the firm or even raising the issue. There is no investigation or disciplinary action against the firm pending yet.

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Finally, as any good acolyte of the Stigler Center and University of Chicago Booth School of Business must do, I looked at the state of competition in the audit industry, at least at a U.S. level. Looking at any issue with regard to the Big 4 at only the U.S. level is, however, now not good enough given the systemic risk to the whole network presented by the failure of cessation of any key hub in the network–U.S. U.K, Australia, China, India, Germany, France/Italy/Spain. My hope was that an update of the Hirschman-Herfindahl Index for the U.S. market for 2014-2016 would encourage more academics–with more time and institutional support– to take up this subject. I have plenty of ideas for anyone so motivated.

The post, “Big Four Audit Firms Enjoy a ‘Too Few to Fail’ Regulatory Hall Pass” comes to what some my think is a surprising conclusion, at least coming for me: The still very significant concentration of large company audits in the Big 4 firms alone may be good thing, if only because a much more dispersed market would be almost impossible for the PCAOB to realistically check a high proportion of the market’s audit quality at all.

Just look at the state of broker-dealer audits. The results are terrible but the PCAOB can’t get to them, or shut the bad ones down, fast enough.

In 2016 PCAOB inspectors identified deficiencies in the work of 96 percent of the audit firms inspected. Auditor independence appeared to be impaired in 7 percent of the inspected audits, compared to 25 percent in 2014.

“While there were fewer independence findings, it is very troubling that we continue to find auditors assisting in the preparation of the financial statements they audit or providing bookkeeping services to their audit clients,” said Robert Maday, deputy director of PCAOB Registration and Inspections and leader of the Broker-Dealer Audit Firm Inspection Program.

The PCAOB adopted a temporary rule to create an interim inspection program that was approved by the SEC on August 18, 2011. Six year later the PCAOB announced its 2017 inspections plans for broker-dealers, still under the temporary rule. Since inception of the interim inspection program through December 31, 2015, the PCAOB reported it had performed 259 inspections of 210 firms that conducted audits of brokers and dealers. As of August 2014 there were reportedly 790 firms that audited 4,302 broker-dealers. By August 2016 the number of firms auditing broker-dealers had gone down to 541, but total inspection coverage is still less than 50%.

In its 2016 annual report on its interim inspection program for auditors of broker-dealers, the PCAOB said that 199 firms or 37 % of the firms that audited broker-dealers only audited one broker-dealer. The highest percentages of auditing deficiencies were identified by the regulator in the inspections of firms that audited only one broker or dealer client while the lowest percentages of deficiencies were identified for firms that audited more than 100 broker or dealer clients.

Inspections staff continued to observe deficiencies in financial statement audit areas similar to previous inspection cycles, including revenue recognition, financial statement presentation and disclosures, and the assessment of risks of material misstatement due to fraud. In addition, PCAOB inspectors observed that auditors did not sufficiently assess relationships and transactions with related parties.

All this to say that, maybe, from a regulatory perspective it’s good that annual inspections of the Big 4 at least hit a high proportion of large company audits. The bad news is that if one of those global audit firms falters financially or fails, “the remaining three will unlikely be able to absorb the clients, the work, and the employees the way four of them did back in 2002 following the failure of Arthur Andersen.”

If only the results of the Big Four firm audits of large issuers gave us any comfort.

Last week, as you know, the PCAOB announced major settlements with two international affiliates of a global network firm.[1]

The settlements relate to instances where firm personnel – some of whom were senior partners with leadership roles at the firm – issued materially false audit reports, altered audit work papers, pressured others within the firm to do the same, withheld documentation, provided false testimony, and did not cooperate with our inspections and subsequent investigation. It was through our enforcement staff’s investigative efforts that the cover-up involving the improperly altered work papers was ultimately discovered.

As described in detail in the orders – which are posted on our website[2] – senior partners, including leaders in the audit practice and individuals serving on one firm’s governance board, set a tone of disregard for compliance with rules and, in one instance, actively thwarted the Board’s oversight.

The audits implicated in both matters were of large multinational corporations, underscoring the importance of regulators around the world to work increasingly collaboratively to address improper behavior.

I view these as extremely serious violations which raise fundamental issues relating to global firm governance, culture and tone at the top.

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About the author

Francine McKenna (@retheauditors) is the Transparency Reporter at MarketWatch.com, a Dow Jones publication, where her work is also featured frequently in the Wall Street Journal. McKenna had more than twenty-five years of experience in consulting and professional services including tenure at two Big 4 firms, both in the US and abroad before becoming a journalist. Look for her prior columns, "Accounting Watchdog" at Forbes.com and "Accountable" at American Banker. For more information, click "About" at the bottom of this page. For more information contact Francine McKenna, fmckenna@mckennapartners.com